It Won’t Be Canberra That Decides the Australian Banks’ Profits

In case you missed it, the RBA met for its regular monthly meeting on Tuesday. Unless you scoured the business sites, though, you wouldn’t have seen it mentioned at all.

As it happens, the RBA left the official cash rate unchanged at 1.5%. Its accompanying commentary could have been plucked from any one of the previous Governor’s statements over the last couple of years. Yes, the world economy is continuing to grow, but at a slower rate than the average.

No need to put your seatbelt on for that one.

While the new Governor’s first meeting at the helm was uneventful, there was plenty of excitement taking place with another banker somewhere else…in Canberra.

At the same time the RBA decision was being announced, the CEO of Commonwealth Bank [ASX:CBA], Ian Narev, was being grilled by the Parliament’s Economic Committee. And I use the word ‘grilled’ lightly.

At its toughest, the questioning was about as penetrating as an ageing medium pacer bowling uphill into a headwind. For those hoping for a knockout punch laying the grounds for a royal commission, nothing was forthcoming.

After the three hour session came to a close, it was quickly back to business for the CBA boss — that night he jetted off to Washington for an International Monetary Fund (IMF) meeting. For the CEOs of the other big three banks lining up to await their turn, they would have breathed a sigh of relief.

All four banks have their own scandals they’re dealing with, ranging from alleged rigging of the bank-bill swap rate, to bungles with superannuation accounts, to overcharging of fees, and right through to the Commonwealth’s much publicised insurance and financial planning fiascos.

For the latter, the faults have been acknowledged, and there is a process in place to rectify this. Compensation is being paid for inappropriate financial planning advice, and a review of rejected insurance claims is expected to be completed by the end of the year.

As humiliating as some of the cases have been for the bank, compensation for the financial planning arms will run into tens of millions of dollars. Barely a drop compared to CBA’s $9.5 billion full-year cash profit.

As much as the pollies on the committee pouted, scowled, glowered and huffed and puffed, my guess is that life for these bankers will get back to normal by around the start of next week. These bankers will get back to what they’re paid to do — making money out of money.

Despite all the bluster, those in Canberra know that they can’t legislate the way in which banks make their profits. What they can do, though, is increase penalties and fines for those that break the rules.

The Treasurer’s announcement the night before the hearing kicked off with the threat that any rigging of benchmark rates will carry a criminal offence in a bid to change banking culture. But that’s in the future — it won’t apply to these current investigations.

Incredibly, the CBA boss conceded that not one individual had been sacked from its insurance arm, CommInsure.

Aussie banks have had a stellar run over the last couple of decades. But the mistake those in Canberra, who are so against the banks, make is to assume that these good times will always roll.

Governments are clueless about trying to pick the economic cycle. You don’t have to look back too far to the Resource Super Profits Tax, and its hastily constructed successor — the Minerals Resource Rent Tax — which the then government implemented at the top of the cycle. The money it raised didn’t even cover the administration cost of setting it up.

The banks’ cycle, too, has peaked, as their share prices over the last 12–18 months illustrate. Apart from the daily sport of speculating whether the Australian property market is heading for a bust, the banks’ profits will be determined by something much more boring than that.

It will come down to something called ‘risk weights’. Yep, there’s no way of making that sound exciting, but they will play an ever bigger part in how banks assign their capital and distribute their profits.

Banks need to carry a certain amount of capital for each loan they make. A loan is a liability to the borrower and an asset to the lender. The idea of risk weights is that the bank matches the risk of its assets with an appropriate level of capital.

A residential mortgage loan in which the borrower has a high level of equity is less risky than an unsecured loan to a small business. Banks charge different interest rates to reflect this risk, but they also hold different levels of capital.

Historically, all Australian banks used a standard risk weighting for each type of assbet. But the Big Four banks and Macquarie Group [ASX:MQG] have been able to use their own internal models since 2007.

As the housing boom progressed, the amount of risk weight capital held by these five institutions has progressively dropped, giving them a distinct advantage over the regional banks (who use the standard model).

The more a bank can stretch its capital, the more loans and profits it can make. And the more dividends it can send to its shareholders.

APRA — the regulatory body charged with overseeing the banks (among other responsibilities) — addressed this gap last year, giving the Big Four (and Macquarie) until 1 July 2016 to increase the risk weightings they hold for residential mortgages. That’s why you saw the banks undertaking capital raisings over the last 12 months.

It’s a move that has been cheered along by the regional banks as it helps level up the playing field. But the unknown is what lies ahead.

The news for the banks is that more changes are likely to come. The Bank of International Settlements in Basel is scheduled to release it next phase of regulatory framework by the end of the year (Basel IV). It’s something APRA will closely review, and it will likely lead to higher risk weightings being assigned to different mortgage types (for example, investor versus owner-occupied).

Another round of capital raisings could be in the works. If these come into effect, it will make the banks stronger and more resilient to future shocks. However, it’s going to make it increasingly difficult for the banks to maintain their returns on equity and high profit levels — and for shareholders, it’ll represent another challenge for the banks to maintain their dividends.

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years.
Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments.
Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible.
Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

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